Do Central Banks Have an Exit Strategy?

SINGAPORE – A year into the global financial crisis, several key central banks remain extraordinarily exposed to their countries’ shaky private financial sectors. So far, the strategy of maintaining banking systems on feeding tubes of taxpayer-guaranteed short-term credit has made sense. But eventually central banks must pull the plug.  Otherwise they will end up in intensive care themselves as credit losses overwhelm their balance sheets.

The idea that the world’s largest economies are merely facing a short-term panic looks increasingly strained. Instead, it is becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning. Weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigor.

If this is the right diagnosis of the “financial crisis,” then efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Not allowing the necessary consolidation is weakening credit markets, not strengthening them.

The United States Federal Reserve, the European Central Bank, and the Bank of England are particularly exposed. Collectively, they have extended hundreds of billions of dollars in short-term loans to both traditional banks and complex, unregulated “investment banks.” Many other central banks are nervously watching the situation, well aware that they may soon find themselves in the same position as the global economy continues to soften and default rates on all manner of debt continue to rise.